As a member of the Finance Department of Ranch Manufacturing, your supervisor ha

Question

As a member of the Finance Department of Ranch Manufacturing, your supervisor has asked you to compute the appropriate discount rate to use when evaluating the purchase of new packaging equipment for the plant. Under the assumption that the firm's present capital structure reflects the appropriate mix of capital sources for the firm, you have determined the market value of the firm's capital structure as follows:

Source of Capital: Bonds with Market Value of 4,200,000, Preferred stock with Market Value of 1,800,000 and Common stock with Market Value of 5,800,000.

to finance the puchase, Ranch Manufacturing will sell 10-year bonds paying 7.3% per year at the market price of $1,061. Preferred stock paying @2.03 dividend can be sold for $24.35. Common stock for Ranch Manufacturing is currently selling for $54.77 a rate of 5.1% per year into the indefinite future. If the firm's tax rate is 30%, what is discount rate should you use to evaluate the quipment purchase?

Ranch Manufacturing's WACC is ___% (Round to three decimal places.)

Explanation / Answer

Bonds - a 1,000 bond selling at 1,061, paying 7.3%, or 73 on 1,061 costs 6.88% before tax, less 30% tax, results in an after tax cost of 4.81%.

Preferred stock pays a dividend of 2.03 on a market price of 24.35, or 8.3%.

Common stock, selling at 54.77 with a constant growth rate of 5.1%, has an expected return of R based on the Gordon growth model, where R = Next Div/Price + G, or R = 3.15/54.77 + 5.1% = 10.85%.

WACC, based on market values:
Bonds - 42 mil @ 4.81% = 2020200
Preferred - 1.8 mil @ 8.3% = 149,400
Common - 6.8 mil @ 10.85% = 737800
Total Cost of 2907,400 on 49.6 mil = 5.86% WACC

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